Current LIBOR Fiasco: Reasons and Consequences

by

Hazik Mohamed1

Context and Overview

LIBOR is the London Interbank Offered Rate. This rate determines the interest rates that
banks pay to borrow money from one another. It is set by large banks submitting to the
Thomson Reuters Corporation the interest rate that they would have to pay to borrow money
in specific currencies at specific time periods. Thomson Reuters then averages these costs
and creates LIBOR quotes. The rate affects the pricing of around 200 trillion of financial
services around the globe and, as such, is one of the most important benchmarks for interest
rates internationally. LIBOR is also used in many instances to determine the financial health
of a bank.
Barclays Capital is believed to have been attempting to manipulate the LIBOR rate since as
early as 2005. The bank frequently gave false information to LIBOR calculators to make it
appear as though its credit quality was better than it actually was while allowing its traders to
profit from rate speculation. Barclays is thought to have engaged in these rate-rigging
practices mainly between 2006 and 2009.
When the LIBOR rate increases, mortgages become more expensive and vice versa.
Hundreds of thousands of mortgages are linked to the LIBOR rate and, as such, Barclays
misconduct may have affected many homeowners personally though not necessarily so and,

The author is the Managing Director at Stellar Consulting Group, and can be reached at hazik@stellarcg.com.
He is also currently a PhD candidate in Islamic Finance at INCEIF in Kuala Lumpur.

if so, probably not to any great degree. As a variety of rates are set relative to the LIBOR rate,
from credit cards to student loans to other financial services, the effects of the rate
manipulation are potentially widespread.

Page 2 of 14

1.0 Introduction
At the end of June 2012, news of a further scandal in the banking industry broke although,
there was widespread knowledge about this problem within the industry. One UK bank,
Barclays, had fines levied by the US and UK authorities for manipulating a key interest rate
index called LIBOR. Other banks are thought to be involved too, and this is still under
investigation.
LIBOR is an important market interest rate indicator because it measures the rate of interest
at which banks can lend to each other, although it does not necessarily measure the rate of
interest at which banks actually do lend to each other. Many other financial contracts are
therefore priced using LIBOR. For example, it would be reasonable for a bank to offer a
mortgage product with a floating rate of interest of LIBOR plus 1.5%. The bank could then
be reasonably sure that, whatever happened to central bank interest rates, it could obtain
funds at LIBOR to fund the mortgage, with a fixed margin for credit risk and expenses. In
addition, many important derivative products are priced using the LIBOR interest rates.
These products are used for long-term risk management purposes as well as being traded.
From this, we see two separate aspects of this scandal emerge. The first was that banks
seemed to have been manipulating the rates that are used to calculate LIBOR so that their
derivative positions on LIBOR contracts would show higher trading profits. The second was
that, at the height of the financial crisis, Barclays bank seems to have reduced its LIBOR
submissions to the British Bankers Association (BBA) in order to give the impression to the
market that others were willing to lend to Barclays at lower interest rates than was actually
the case. The idea of this action was to give the impression to the market that those lending
money to Barclays were less concerned about the credit risk of Barclays than they were in
practice.

Page 3 of 14

Neither of these actions are victimless crimes. In the first case, Barclays could have made
trading profits on derivative products tied to LIBOR whilst the other party to the trade made a
loss (as profits and losses must sum to zero). In the second case, banks could have been
tempted to lend to Barclays at rates of interest that did not reflect the true credit position of
Barclays because lenders would have seen the relatively low rates of interest at which
Barclays claimed everybody else was lending. However, there is a twist in the tail of the
second incident. It has been suggested that Barclays declared low LIBOR rates with the tacit
encouragement of one or more of the Bank of England, the Financial Services Authority
(FSA) or the Treasury or, at least, it is claimed that messages were communicated from one
or more of these organisations that were ambiguous.

2.0 The LIBOR Fiasco

Barclays were found guilty of rigging LIBOR which is a series of interest rates posted by the
British Bankers Association, covering ten different currencies, and repayment periods
between one day and a year in length. The rates are calculated by averaging submissions from
member banks as to what interest they would expect to pay if they borrowed money from
other banks. As such, the rates are, in part, a measure of the health of the financial sector:
submitted estimates are high when confidence is low, and vice versa. Barclays were found to
have submitted unrealistically low estimates during and after the 2008 credit crunch, in order
to make themselves appear healthier than in reality.
But LIBOR is about more than just the perceived health of the finance sector. Worldwide,
around US$350 trillion of financial derivatives are linked to one or other of the LIBOR rates,
so changes in the latter affect the price at which these derivatives are traded. Barclays were
also punished because, among other things, their traders obtained advance notice of submitted
estimates, allowing them to tailor their trading patterns more profitably. The bank itself also
Page 4 of 14

adjusted its submissions to profit from derivatives trading: one trader estimated that a 0.01%
change in LIBOR (either way) could net a couple of million dollars (a simple calculation of
this will be shown in the next section). This falsification of LIBOR affects more than just
derivative trading; mortgages, loans, and other retail financial products often have their
interest rates tied to this marker. As of December 15, 2012, 16 banks were allegedly involved
in manipulating the rate.

2.1 Reasons to manipulate LIBOR

There are several reasons for the manipulation of LIBOR, and the following explanation may
provide an insight into the motivation for some to do so :
LIBOR is used to settle contracts on money market derivatives. Every day, 23 banks are
polled by the BBA and asked the question, "At what rate could you borrow funds, were you
to do so by asking for and then accepting inter-bank offers in a reasonable market size just
prior to 11 am?"
The 23 banks all submit responses, telling the Thomson Reuters data collection service that
handles LIBOR submissions the price they would offer to loan money (LIBOR) on a variety
of different timetables. The service throws out the top and bottom four submissions, then
takes the average of those submissions to determine these official BBA rates.
Bets involving Eurodollar futureswhich allow traders to take bets on how interest rates will
move over certain time periodscaused Barclay's submitters to alter the lending rates they
reported to the BBA that would make up LIBOR. Eurodollar futures (and the derivatives
related to them) accounts for some US$360 trillion in global trade, and typical contracts value
at a minimum of US$1 million.

Page 5 of 14

It's no surprise, then, that Barclays stood to gain a lot of money off of even small changes in
the LIBOR rategenerally just a few basis points.
One example, from the FSA report : Final Notice to Barclays Bank PLC. on June 27, 2012,
top of page 12 :
On Friday, 10 March 2006, two US dollar Derivatives Traders made email requests for a low
three month US dollar LIBOR submission for the coming Monday:
i. Trader C stated We have an unbelievably large set on Monday (the IMM). We need a
really low 3m fix, it could potentially cost a fortune. Would really appreciate any help;
ii. Trader B explained I really need a very very low 3m fixing on Monday preferably we
get kicked out. We have about 80 yards [billion] fixing for the desk and each 0.1 [one basis
point] lower in the fix is a huge help for us. So 4.90 or lower would be fantastic. Trader B
also indicated his preference that Barclays would be kicked out of the average calculation;
and
iii. On Monday, 13 March 2006, the following email exchange took place:
Trader C: The big day [has] arrived My NYK are screaming at me about
an unchanged 3m libor. As always, any help wd be greatly appreciated.
What do you think youll go for 3m?"
Submitter: I am going 90 altho 91 is what I should be posting.
Trader C: [] when I retire and write a book about this business your
name will be written in golden letters [].
Submitter: I would prefer this [to] not be in any book!

Essentially, Traders B and C begged the person responsible for submitting Barclays's LIBOR
number to lower the rate they submitted for that day on three-month lending. [Even if
Barclays's submission had gotten thrown out because it was unnaturally low, during the
period before the crisis, the bank was generally submitting high rates, so a thrown out
submission would have pulled the final LIBOR down.]
Page 6 of 14

That was because they had US$80 billion in three-month forward interest rate swaps (IMMs)
"fixing" on March 13. We will not go into the details of how this swap is constructed. But in
essence, traders enter into these swap agreements, betting that interest rates will go down
versus some fixed rate set forward in the contract. Thus, the larger the difference between the
fixed rate and LIBOR (a floating rate that changes daily), the more money they make.
A complete explanation of how this works is available in Dr. Galen Burghardt's "The
Eurodollar Futures and Options Handbook." For now, we will just use an equation from that
volume to determine how much Barclays would have made off from a 3-month LIBOR rate
(here, floating rate) that was just one basis point lower :

Had Barclays traders actually affected the rate by one basis point, they would have made
more than $2 million. This is just one trade, and these contracts settle quite frequently.
Further, it's likely that Barclays was not the only bank fiddling with these numbers.
In this situation, a counterparty that sold them the IMM swap would have taken the trading
loss. To some extent, the fact that financial firms, and not the common man, appear to have
taken the losses here means that manipulation of LIBOR rates has not become a matter of
public outcry. Even so, such distortions in the market demonstrate a fundamental flaw in the
system by which much of the world's lending is organized.

3.0 Consequences of the banking scandals surrounding LIBOR manipulation

For a start, the entire syndicated loan market is undermined. It is hard for us to remember a
world before the money markets before LIBOR was coined to describe the rates at which
Page 7 of 14

they lent to each other on them. For LIBOR dates back to the 1960s, to the early days of the
Eurocurrency markets, when London-based banks hit on the idea that they might trade
deposits with each other over the phone, instead of relying on their own deposit base to fund
their loans. (It is the London Interbank Offered Rate.) Syndicated lending, splitting loans
between a group of banks took off on an international scale when banks were confident they
could go into the market and buy the deposits they needed to fund their bit of the loan.
So without the London-based deposit markets, the great expansion of the world economy
would have had to be financed by securities markets instruments. Undermine confidence in
the pricing of those deposit markets and the entire banking system of the past 50 years is
undermined. If you do not trust LIBOR, you have to peg loans to something else.
This is possible. Before the present system, all rates were tied to one set by the central bank,
in the case of the UK it was Bank rate. Many mortgages are still tied to Bank rate's successor,
base rate. That is causing losses for many banks because base rate is so low that they are
losing deposits, but at a retail level there is enough stickiness to enable the system to work.
At a commercial level, money is less sticky. Large depositors shift cash around for the best
rate or rather the best rate from a panel of banks they deem safe. If big depositors take their
money away from banks, putting it perhaps in government bonds, those banks cannot fund
their loan book. The result is they make fewer and/or smaller loans.
The next effect of a loss of trust in LIBOR is a loss of trust in banking as an industry. Banks
are being urged to raise more capital to protect themselves and their depositors. But they have
over the past four years been a terrible investment. The graph below shows how, apart from
Japan, banks are worth less than half the level they were at in 2003, relative to the market as a
whole. This is not a pretty prospect for investors, made worse if the bank may be sued. If
banks cannot raise more capital they have to shrink their balance sheet. In other words, they
have to make fewer and smaller loans.
Page 8 of 14

Put this together and there are at least three ways the LIBOR disaster will undermine banking
globally.
1. Bankers will be more cautious. They will be custodians of other people's money
rather than go-getters taking risks, as they will punished if the risks go wrong and not
rewarded if they go right.
2. The cost of fines and other legal actions will reduce their profits, which are needed to
help build up their capital base. If banks cut dividends, or delay their return to paying
them, that reduces their hope of raising new capital.
3. Their core commercial business of making loans tied to LIBOR has been undermined
and will shrink.
And finally, aside from the direct impact on their capital-raising ability, there is an indirect
impact on its reputation.

3.1 Ramifications for the banking world

In September, the BBA agreed to turn over control of the rate to regulators. Martin Wheatley,
the managing director of the U.K.'s Financial Services Authority (FSA) has called LIBOR
Page 9 of 14

"no longer fit for purpose." Wheatley has proposed that a yet-to-be-created administrator post
should assume control of the rate from the BBA, and that the current pool of 23 banks that set
LIBOR should be expanded.
Wheatley also evaluated the 50 largest banks in Britain on market expertise and participation
and found Wells Fargo, Morgan Stanley and Goldman Sachs scored higher than several of
the banks currently involved in rate-setting. While the three U.S. banks have not commented
on the findings, it is no leap to expect these three will be asked to take some role in the
revamp of LIBOR.
Fines
UBS is not the only bank facing a whopping fine, after Barclays was fined US$450 million
for its involvement, and Barclays' chief executive Bob Diamond and chairman Marcus Agius
resigned as a result of the scandal. According to the U.K.'s Financial Services Authority,
Barclay's LIBOR manipulation could date as far back as 2005.
At a hearing in Berlin this week, Deutsche Bank executives said that the bank had set aside
reserves for possible fines, but did not expect to have to pay U.S. claims. Deutsche Bank
admitted in July that a "limited number" of staff were involved in the scandal, but reiterated
in Berlin that no senior officials had "behaved inappropriately."
The Royal Bank of Scotland is expected to face fines from both U.S. and U.K. authorities.
RBS Chief Executive Stephen Hester has said the bank wants to settle with regulators as soon
as possible, and that the bank will face a "miserable day" when the fines are levied.
Regulation
In a letter to Treasury Secretary Geithner, Senators Chuck Grassley (R-IA) and Mark Kick
(R-IL) have called for an American-based interest rate index. (Senator Grassley from the
Page 10 of 14

Grassley Amendment in the STOCK Act.) CFTC Chairman Gensler has proposed LIBOR be
tied to market transactions, rather than banks' estimates of its interbank borrowing costs.
Former Citigroup Chairman and CEO Sandy Weill, considered one of the driving forces
behind the considerable financial deregulation and mega-mergers of the 1990s, surprised
financial analysts in Europe and North America by calling for splitting up the commercial
banks from the investment banks.
It is clear from both the fines and the cross-Atlantic investigations that LIBOR would not be
allowed to continue as-is. It might be abolished entirely, subject to transformation and
transformative oversight, or abandoned by U.S. banks in favour of another index.

3.2 Repercussions for banking consumers and investors

The implications of LIBOR will be felt by investors during quarterly and annual earnings,
and by consumers whose borrowing rates are tied to the rate. There will be more to come in
the weeks and months ahead as the full impacts of a LIBOR revamp take hold.
4.0 Conclusion
The LIBOR fixing may have more serious implications for regulation. The setting of LIBOR
was one of the few areas of self-regulation remaining in an increasingly rule-bound financial
world. The assumption that reputational concerns and self interest would bind banks to report
honestly their cost of funding has been shown to be misplaced. The demands for more
onerous regulation are increasing, although it is not clear that the extra rules being mooted
will solve cultural problems or excessive risk taking. Once again, it is not just Barclays that is
in the frame here, but the entire banking sector.

Page 11 of 14

Perhaps the LIBOR scandal suggests that we have to return to other approaches to regulating
markets. We should ask whether, in fact, regulators have the ability to write detailed rules
that will anticipate every possible action and set instructions for those actions. We should ask
whether this approach prevents the development of discerning behaviour and crowds out the
development of regulation generated within the market itself. We should ask whether basic
principles of civil and criminal law can be used to deal with the offence committed in the
scandal we have witnessed. Or perhaps we should look into a new innovative benchmark that
can be trusted - one that can be free from manipulation and dishonesty.

Page 12 of 14

Appendix

Table 1 : The use of LIBOR in financial contracts

Table 2 : The use of LIBOR as a reference rate

Page 13 of 14

5.0 References

Bank of England. 2007. Minutes: Sterling Money Markets Liaison Group. November 15.
Available at: www.bankofengland.co.uk/markets/Documents/money/mmlgnov07.pdf
British Bankers Association (BBA). 2012. bbalibor Explained.
Available at: www.bbalibor.com/bbalibor-explained
Commodity Futures Trading Commission (CFTC). 2012. Order Instituting Proceedings
Pursuant to Sections 6(c) and 6(d) of the Commodity Exchange Act, as Amended,
Making Finds and Imposing Remedial Sanctions. Docket No. 1225. June 27.
Available at:
www.cftc.gov/ucm/groups/public/@lrenforcementactions/documents/legalpleading/en
fbarclaysorder062712.pdf

Federal Reserve Bank of New York. 2012. New York Fed Responds to Congressional
Request for Information on BarclaysLIBOR Matter. July 13.
Available at:
www.newyorkfed.org/newsevents/news/markets/2012/Barclays_LIBOR_Matter.html.
Financial Services Authority (FSA). 2012. Final Notice to Barclays Bank PLC. June 27.
Available at: www.fsa.gov.uk/static/pubs/final/barclays-jun12.pdf
House of Commons Treasury Committee. 2012. Evidence from Paul Tucker, Deputy
Governor, Bank of England. July 9.
Available at: www.parliamentlive.tv/Main/Player.aspx?meetingId=11191
. 2012. Evidence from Robert Diamond, Former Chief Executive, Barclays Bank. July
4. Available at: www.parliamentlive.tv/Main/Player.aspx?meetingId=11170.
US Department of Justice (DoJ). 2012a. Non-prosecution Agreement, Barclays Bank PLC.
Criminal Division, Fraud Section. June 26.
Available at: www.justice.gov/iso/opa/resources/337201271017335469822.pdf
. 2012b. Statement of Facts. Appendix A to Non-prosecution Agreement, Barclays
Bank PLC. Criminal Division, Fraud Section. Available at:
www.justice.gov/iso/opa/resources/9312012710173426365941.pdf

Page 14 of 14